Second Quarter 2015 Letter to Clients

Of all the temptations long-term investors must overcome, perhaps none is more daunting than finding a way to resist making changes to one’s investment portfolio based on conventional wisdom.

The phrase itself is worth examining. Famed economist John Kenneth Galbraith is credited with coining the modern-day usage of “conventional wisdom,” which he used to describe the concept of “ideas at any time that are esteemed for their acceptability.”

Galbraith did not use the term in a positive sense. He was criticizing the sort of groupthink that plagues people of any given era, convincing them to buy into beliefs that are universally held to be true simply because everyone holds them to be true. Rational analysis and critical thinking are often sacrificed in the process.

In the investment realm, conventional wisdom is the siren song that whispers in your ear about how things are and, by extension, where they must be headed. In 1999, it was the idea that we were in a “new era” for stocks in which earnings and valuations no longer mattered. In 2007 it was the notion that the housing market couldn’t go down in value. In 2009 it was the belief that gold was the only truly “safe” investment in a world where the U.S. dollar was no longer going to be the world’s reserve currency.

Millions of people made changes to their investment portfolios based on these ideas, because they seemed so right at the time. And yet in each case they proved to be wrong.

There are many such notions floating around in the conventional wisdom today. These notions are widely held by most investors and, on the surface, seem quite logical. As is usually the case with conventional wisdom, however, closer examination of these ideas reveals fundamental flaws in the assumptions. We examine three of these issues in detail below:

Greece: Conventional wisdom holds that Greece’s departure from the Eurozone would take the European Union economies into uncharted territory, sparking a new round of economic instability in Europe and causing a steep selloff in global stock markets.

The real impact of such an event, however, is far from clear. Greece’s economy – at least what’s left of it – accounts for only a tiny fraction of the global capital markets. The market capitalization of Apple Inc., for example, is more than twice the entire GDP of Greece. In a well-diversified equity portfolio, exposure to Greece would likely be less than a half-percent of the equity allocation.

The larger fear among investors, of course, is the risk of “contagion” – the fear that an exit by Greece from the Eurozone will start additional dominos falling, such as Italy, Spain and Portugal. Even if such a scenario did come to pass, however, the impact on global stock markets is hard to predict. A wider economic crisis in Europe could result in a selloff in stock markets, but it would also provide some long-overdue resolution to the endless Eurozone economic soap opera. Markets often rally strongly once lingering unknowns suddenly become known. This was the case in prior global crises in Russia and Asia in the late 1990s, and again following the U.S. debt ceiling crisis in 2011. In both of those cases, stocks experienced a deep downturn before suddenly rebounding a few weeks later and recovering all of their losses and then some. Investors who bailed out of the market after the initial downturns only locked in their losses while missing out on the unexpected recoveries that quickly followed.

Rising interest rates: Conventional wisdom holds that the stock market has surged as a result of the ultra-low-interest rate environment that was ushered in as a result of the 2008-09 financial crisis. When rates begin to rise, the thinking goes, money will flood out of stocks and into bonds, causing a prolonged period of low total returns for stocks.
History doesn’t necessarily agree with this assumption, however. While stocks often experience short-term volatility when interest rates rise, the longer-term returns for stocks in rising interest rate environments are often strongly positive, or at least historically typical. More importantly, stock returns often exceed bond returns in such environments.

The following table shows the total return of stocks and long-term bonds during the most significant rising-interest-rate periods of the past 50 years. Note that in 12 of the 14 periods shown, stocks outperformed long-term bonds. Also note that stocks only experienced two periods of negative returns – in the early 1970s – while bonds experienced seven periods of negative returns.
Also consider that the current period of prolonged low interest rates is not historically unparalleled. In fact, from the early 1930s through the early 1950s, the yield on the 10-year U.S. Treasury bond stayed below 3% for the entire twenty year period:


                                                                                      Source: Goldman Sachs, Inc.

Stock Valuations: Conventional wisdom from pundits today is that stock valuations are “too rich.” They point to the long bull market that has been ongoing for the better part of six years now and contend that this upward climb can’t be sustained much longer.

Certainly the market is due for a pullback; historically one out of every three years has been negative for the S&P 500. But this kernel of truth can blind investors to the larger reality of stock performance. The fact is there have been many periods of time when stocks have sustained a long bull run, most notably in the 17-year period from 1982-1999. While downturns are inevitable, when those occur and how deep and how long they go are unknowable. Investors in the past who saw record highs as an indication to pare back stock exposure have often watched the stock market continue to move higher for many years after, missing out on big gains in the process.

And while the historical price-to-earnings ratio of the S&P 500 has moved higher in the past few years, it is still within the realm of historical norms, as indicated in the following chart:

The common denominator with each of the aforementioned issues is that their impacts on stocks in the short term can’t be known ahead of time. History offers plenty of examples for both bears and bulls to make whatever case they will make as to why such events will or won’t have a negative short-term impact on stocks.

The case for long-term investors, however, is much clearer. Given that the major market indices all hit record highs earlier in 2015, it is fair to say that no single crisis of the past has kept the stock market from moving ever-upward in the long run. Clearly, then, having the patience and discipline to ignore the day’s conventional wisdom and stay the course is what matters most when it comes to long-term investment success.